Paper 3, Section II, J

Stochastic Financial Models
Part II, 2013

Suppose that (εt)t=0,1,,T\left(\varepsilon_{t}\right)_{t=0,1, \ldots, T} is a sequence of independent and identically distributed random variables such that Eexp(zε1)<E \exp \left(z \varepsilon_{1}\right)<\infty for all zRz \in \mathbb{R}. Each day, an agent receives an income, the income on day tt being εt\varepsilon_{t}. After receiving this income, his wealth is wtw_{t}. From this wealth, he chooses to consume ctc_{t}, and invests the remainder wtctw_{t}-c_{t} in a bank account which pays a daily interest rate of r>0r>0. Write down the equation for the evolution of wtw_{t}.

Suppose we are given constants β(0,1),AT,γ>0\beta \in(0,1), A_{T}, \gamma>0, and define the functions

U(x)=exp(γx),UT(x)=ATexp(νx)U(x)=-\exp (-\gamma x), \quad U_{T}(x)=-A_{T} \exp (-\nu x)

where ν:=γr/(1+r)\nu:=\gamma r /(1+r). The agent's objective is to attain

V0(w):=supE{t=0T1βtU(ct)+βTUT(wT)w0=w},V_{0}(w):=\sup E\left\{\sum_{t=0}^{T-1} \beta^{t} U\left(c_{t}\right)+\beta^{T} U_{T}\left(w_{T}\right) \mid w_{0}=w\right\},

where the supremum is taken over all adapted sequences (ct)\left(c_{t}\right). If the value function is defined for 0n<T0 \leqslant n<T by

Vn(w)=supE{t=nT1βtnU(ct)+βTnUT(wT)wn=w}V_{n}(w)=\sup E\left\{\sum_{t=n}^{T-1} \beta^{t-n} U\left(c_{t}\right)+\beta^{T-n} U_{T}\left(w_{T}\right) \mid w_{n}=w\right\}

with VT=UTV_{T}=U_{T}, explain briefly why you expect the VnV_{n} to satisfy

Vn(w)=supc[U(c)+βE{Vn+1((1+r)(wc)+εn+1)}]V_{n}(w)=\sup _{c}\left[U(c)+\beta E\left\{V_{n+1}\left((1+r)(w-c)+\varepsilon_{n+1}\right)\right\}\right]

Show that the solution to ()(*) has the form

Vn(w)=Anexp(νw),V_{n}(w)=-A_{n} \exp (-\nu w),

for constants AnA_{n} to be identified. What is the form of the consumption choices that achieve the supremum in ()(*) ?